Another economics department to close

Today I decided that there is another macroeconomics research unit that needs to be closed down. My decision was reached after I read the latest paper from the Bank of International Settlements – The future of public debt: prospects and implications – which confirms that the Monetary and Economic Department of that organisation is publishing deficit terrorist literature. The paper is so bad that I am sorry I read it. I may avoid BIS publications altogether in the future. But if I apply that reasoning I am going to be back to reading Stieg Larsson novels and there are only three of them and I have already read them!One economics department closes that shouldn’t

The title of this blog is a double-entendre and relies on the sometimes imprecise nature of English. You may not know this but the University of Notre Dame in the US has been trying to get rid of any semblance of non-mainstream economics at their institution. In 2003, as a first step, they forcibly split the economics department into two separate departments.

On the one hand, the Economics & Policy Studies Department, which is a liberal social science outfit and describe themselves as “Committed to values and socio-economic justice. Open to alternative theories and approaches. Interested in devising effective policies. Providing students with solid training in economics that matters”

And on the other hand, the The Department of Economics and Econometrics, the latter describing itself as “a neoclassical economics department committed to rigorous theoretical and quantitative analysis in teaching and research”.

My description of the latter is that they undertake erroneous and misleading research and teaching and are irrelevant to anything important facing the world.

Anyway, the final chapter is now being played out and the university has announced that the heterodox department has been closed. You can read about it from David Ruccio’s blog – he is a professor in the department being closed. He writes:

Readers should know that the implications of the decision are much broader than the fate of ECOP faculty. It shows how university governance has dramatically changed, at Notre Dame and elsewhere, in undermining faculty and student input. The basic idea is, they should shut up and tend to their “own affairs” (teaching, churning out publications, and studying) and let the administration go about its work in remaking the university. It also shows how closed the discipline of economics remains – even after the crises of capitalism that have called into question every facet and dimension of mainstream economics, from basic theory to policy recommendations. Finally, it shows how fragile and threatened academic freedom is, at Notre Dame and throughout higher education in the United States.

So Vale liberal thinking.

While another economics department should be closed

But I have identified one “economics department” that should be closed. The BIS authors, noted in the introduction, identify themselves for dismissal almost immediately – their language gives them away. This document is being held out as a piece of research from the BIS yet you read descriptive terminology such as “an explosion of public debt” and “enormous future costs” and “increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways” as samples of hyperbole that riddle the document.

If I was given this paper to referee for a reputable academic journal (a task I do often) I would reject it immediately because of the emotional narrative. And that would be irrespective of the argument and case being made – which also happens to be deplorable.

You have to ask what is an explosion of public debt? When does an increase in public debt explode? What is the comparison between a bomb going off and a rise in nominal public debt liabilities?

You have to ask what are enormous future costs when the paper is talking purely in terms of financial flows which are performed by sovereign governments at zero marginal cost – being electronic in nature. The government is not revenue-constrained and does not have to sacrifice anything other spending desires to ensure the debt is serviced and repaid. There are real resource implications which only really become binding when the economy reaches full employment. Then some choices have to be made.

Further, the rise in public debt didn’t “finance” any government spending for the sovereign governments. It is the other way around – the governments just borrowed back what they had net spent. This is not just a play on words. It is a crucial aspect of understanding how the currency works and interacts with the monetary system via government and non-government sector transactions. Clearly the BIS staff don’t understand that and should resign immediately.

Finally, after misleading their readers with erroneous references to “financing”, the authors go one step further and want us to believe that the stimulus responses which led to the rise in public debt were examples of the “extravagant ways” of governments. The implication is that extravagance is bad and so the stimulus interventions were bad (and thus wasteful and indulgent) and the rest of the nonsensical logic follows.

What do they think would have happened if there had not been a substantial stimulus? Why not acknowledge that the debt increase is just the manifestion of the portfolio diversification opportunity provided by the government to the non-government sector – that is, exchanging a zero interest reserve balance for an interest-bearing risk-free bond?

Even their own narrative is inconsistent. In the opening sentences they say:

Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand.

Forced doesn’t sound like extravagant!

This is not to say that I agree with the composition of the fiscal packages in different countries and we have to be careful to differentiate true fiscal interventions from essentially reserve additions via the quantitative easing. You cannot add those two together as fiscal policy changes.

As is commonplace among these sorts of articles/commentaries (I won’t call this a research paper for obvious reasons noted above), the authors have a clear agenda but realise that the basic facts – those nuisances – are not particularly consistent. So they have to workaround the facts but cannot really ignore them.

So before launching into their agenda they are forced to make some obvious references:

Should we be concerned about high and sharply rising public debts? Several advanced economies have experienced higher levels of public debt than we see today. In the aftermath of World War II, for example, government debts in excess of 100% of GDP were common. And none of these led to default. In more recent times, Japan has been living with a public debt ratio of over 150% without any adverse effect on its cost. So it is possible that investors will continue to put strong faith in industrial countries’ ability to repay, and that worries about excessive public debts are exaggerated. Indeed, with only a few exceptions, during the crisis, nominal government bond yields have fallen and remained low. So far, at least, investors have continued to view government bonds as relatively safe.

But of-course this isn’t consistent with their agenda and so the facts quickly give way to the speculation and poor economics.

They claim that “bond traders are notoriously short-sighted” and will eventually realise that in “the face of rapidly ageing populations … the path of pre-crisis future revenues was insufficient to finance promised expenditure”. They then conclude that:

… the question is when markets will start putting pressure on governments, not if. When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways? …

It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk.

First, bond speculators are not investors they are speculators. Investment has a special meaning in economics – the addition to the productive capital stock.

Second, apart from in some selected EMU nations, there is no likelihood in the near future – that period which will cover the early recovery period – of bond yields rising even under current issuance arrangements. The only thing that will put the nascent (teetering on double dip) recovery at risk is the sort of policies the BIS are advocating – that is, immediate fiscal retrenchment.

I have several triggers which tell me that a writer doesn’t know much about the way the monetary system works or doesn’t want to tell their readers about the nuances because it would weaken (destroy) their argument. One of these triggers appears in this paper in Table 1 – the comparison of the public debt situation in Greece, Ireland and Italy with that prevailing in the UK and the USA.

For example, they say:

A key fact emerging from the table is that over the past three years public debt has grown rapidly in countries where it had remained relatively low before the crisis. This group of countries includes not only the United States and the United Kingdom but also Spain and Ireland.

This so-called “key fact” is a meaningless comparison. The EMU nations have a financial problem, the other nations (USA and the UK) do not. Simple as that. All nations share the real problem that the recession has brought – low income growth, high unemployment etc. But the solvency and debt-servicing problems in this case are confined to the EMU nations.

The BIS staff must know that so why do they persist in conflating these non-applicable pairs? My bet is they know everyone is focused on Greece and is assuming things are bad there so linking them in the same paragraph allows them to leave the reader to conclude that things are bad in the USA and the UK as well. This is just deception.

But their argument becomes clear:

… unless action is taken almost immediately, there is little hope that these deficits will decline significantly in 2011. Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery.

The reality is that the deficits will likely rise if immediate austerity strategies are introduced.

But more importantly, their assertion that the projected deficits are mostly “structural” is unproven and severely tainted by the flawed methods and assumptions they use to decompose the structural from the cyclical.

I wrote a primer on this topic of structural deficits in this blog – Structural deficits – the great con job!. The conclusion is that whenever you hear to term “structural deficit” coming from a mainstream economist you can conclude the measures are deliberately skewed to suit their ideological pre-occupations. You might also like to read the blog – Structural deficits and automatic stabilisers – for more discussion on this point.

The essence is this. The federal budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. One might assume that it is reasonable to conclude that when the budget is in surplus the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit the fiscal impact is expansionary (adding net spending).

However, things are more complicated than that. We cannot conclude that changes in the fiscal impact reflect discretionary policy changes because there are automatic stabilisers operating. To see this, the most simple model of the budget balance we might think of can be written as:

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the Budget Balance are the so-called automatic stabilisers

In other words, without any discretionary policy changes, the Budget Balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the Budget Balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the Budget Balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.

So if the budget goes into deficit we cannot necessarily conclude that the Government is seeking to expand the economy.

To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The change in nomenclature is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.

The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.

So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus when calibrated to full employment, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit when calibrated at full employment.

An industry developed among economists – dealing with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s.

Things changed in the 1970s and beyond. At the time that governments abandoned their commitment to full employment (as unemployment rise), the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) entered the debate – see my blog – The dreaded NAIRU is still about – for more on this.

The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments. It was argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Instead full employment occurred when the unemployment rate was at the level where inflation was stable.

NAIRU theorists then invented a number of spurious reasons (all empirically unsound) to justify steadily ratcheting the estimate of this (unobservable) inflation-stable unemployment rate upwards. So in the late 1980s, economists were claiming it was around 8 per cent. Now they claim it is around 5 per cent. The NAIRU has been severely discredited as an operational concept but it still exerts a very powerful influence on the policy debate.

Further, governments became captive to the idea that if they tried to get the unemployment rate below the NAIRU using expansionary policy then they would just cause inflation. I won’t go into all the errors that occurred in this reasoning. In my recent book with Joan Muysken – Full Employment abandoned we consider these debates in considerable detail. But the point is that the NAIRU is an concept devoid of operational meaning.

But the mainstream never let some facts get in the way – and still measure full capacity utilisation by the NAIRU. So if the economy is running an unemployment equal to the estimated NAIRU then these clowns concluded that the economy is at full capacity. Of-course, they kept changing their estimates of the NAIRU which were in turn accompanied by huge standard errors. These error bands in the estimates meant their calculated NAIRUs might vary between 3 and 13 per cent in some studies which made the concept useless for policy purposes.

But they still persist in using it because it carries the ideological weight – it underpins the neo-liberal attack on government intervention.

So they changed the name from Full Employment Budget Balance to Structural Balance to avoid the connotations of the past that full capacity arose when there were enough jobs for all those who wanted to work at the current wage levels. Now you will only read about structural balances.

And to make matters worse, they now estimate the structural balance by basing it on the NAIRU or some derivation of it – which is, in turn, estimated using very spurious models. The estimates are always far above what a true full employment state would be. This means their estimates of when the economy reaches “full capacity” also underestimate potential output.

Armed with these measures, they then compute the tax and spending that would occur at this so-called NAIRU level of activity. But it severely underestimates the tax revenue and overestimates the spending (because it is still contaminated by the automatic stabilisers).

But the important point is that the flawed methodology leads them to conclude that the true “structural balance” (read: full employment surplus) is more in deficit (less in surplus) than it actually is.

They thus systematically understate the degree of discretionary contraction coming from fiscal policy. As a consequence they will always claim that discretionary fiscal contraction has to occur well before the automatic stabilisers (coming from the renewed growth) have exhausted. This means they are always exerting a deflationary bias into economies which explains why unemployment rates have been persistently high in almost all advanced nations for the last 35 years.

RR pops up again

A second trigger I have noted that tells me immediately that a commentator/writer is a crook is if they quote Reinhart and Rogoff (RR) on public debt defaults and apply it to all nations without qualifying whether they are talking about public debt denominated in domestic currency as opposed to public debt denominated in foreign currencies.

The authors do invoke the erroneous RR analysis without qualification. Their analysis falls in a heap as a consequence. Please read my blog – Watch out for spam! – for more discussion on why RR should be largely ignored.

To bring further add “gravity” to the situation the authors claim:

Many countries have a clear deficit bias.

This conclusion is drawn by charting fiscal positions in the advanced nations since the 1970s. Not surprisingly, there were deficits interspersed with periods of surplus as governments, driven by free market ideology, attempted to follow the neo-liberal logic that told them surpluses represented saving. In all our known fiscal history, every time governments have pursued surpluses, recessions have followed. I exclude nations with strong external positions from this conclusion.

However, if they had charted the same countries since 1945, the “bias” towards deficits would have been even more apparent. Which just signifies that the private sector has mostly had a bias towards saving over the same period. For countries with external deficit positions (most), the budget surpluses always coincided with private domestic deficit positions.

That is, the private sector was increasing their indebtedness and as we have seen, categorically, that is an unsustainable growth strategy.

I wondered why the authors failed to present the whole picture – that the public deficits were supporting the private surpluses (saving) and net wealth accumulation and the public surpluses were associated with the opposite?

They are either too blinkered or too devious in intent to realise these national accounting relationships. I could have written their paper in exactly the opposite way – any time public debt is mentioned I would have emphasised the positive impact on private wealth stocks etc. It really matters that people understand these sectoral associations that underpinning Modern Monetary Theory (MMT).

The mainstream always fail to bring the whole picture together and thus end up arguing inconsistent positions – like we need to run down debt levels every where even though we are running an external deficit. You can do that but only at the expense of a global depression and ultimately significant increases in public debt as the automatic stabilisers strike with a vengeance.

Unless of-course you also advocate, as I do, that the government abandons the gold standard hangover of issuing debt $-for-$ to match its net spending position. It is totally unnecessary – has no implications for anything important – and just gives people the jitters for no reason!

If that wasn’t bad enough

The BIS authors then get onto “long-term fiscal imbalances” and launch into the ageing population terror campaign. They say:

More worryingly, the current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply … Added to the effects of population ageing is the problem posed by rising per capita health care costs.

This leads us to the obvious conclusion that any assessment of the government fiscal situation based on a short-term perspective is incomplete and at best misleading. A key question is to what extent such accrued liabilities should be reflected in debt estimates. Concerns about both fiscal sustainability and intergenerational equity demand that the accumulated net discounted value of all future revenues and expenditure commitments scheduled in current laws be added to the current debt stock. Currently, however, there is no unique source providing such estimates.

But not to be worried by the lack of such estimates they choose to quote highly flawed studies that show the “present value of unfunded liabilities arising from ageing – is very large.” This is a totally irrelevant observation.

Any “financial” estimates of likely trends in budget balances are largely irrelevant. I guess their relevance lies in the fact that they will provide work for some economics graduate. But this is just “make work” and nothing more than boondoggling. Anyone who is employed to do this sort of work is not in a real job. That assessment pretty much applies to most of the financial sector!

Anyway, as the population ages different types of real goods and services are required. Less primary school buildings and more aged care facilities. These sort of compositional shifts in public provision.

The only questions that are important in this debate are:

1. Will there be enough real resources available in the future to build aged care facilities (perhaps via refurbishing schools spaces)?

2. Will the younger generation support politically (via the ballot box) governments using these real resources to provide such facilities?

End of story! I never see analysis of these questions yet they are the only issues that matter.

If there are real resources available for purchase then the government will always be able to purchase them subject to having a political mandate to do so.

Rising dependency ratios matter because productivity has to increase to ensure there are enough real goods and services provided to meet the growing demand. That tells you that it is paramount that governments spend now to educate its population to the highest levels possible and be prepared to provide high quality public infrastructure to support production.

That sort of vision for the public sector is the anathema of what the “fiscal austerity camp” represents.

… it just gets worse

Next stop is the interest rate explosion that is about to happen which will cause:

… the debt ratio will explode in the absence of a sufficiently large primary surplus.

At which point the governments either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.

Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided. They just assert it is going to happen and we are regaled with some graphs that compare Greece and other EMU countries to the US, Australia, Japan etc.

I wonder how long we will have to wait for Japan to explode? They have been carrying debt levels almost twice that specified by RR as being the insolvency (defaulting) threshold for twenty years to date … and nothing has happened. BIS authors on this topic – nothing!

Moreover any attempted return to large primary surpluses would help to ensure that the real interest rate was above the growth rate as economies collapsed again.

They then engage in a pictorial exercise which provides their debt projections. They are irrelevant and dangerous given the position that the authors hold (that is, economists working for the BIS).

For example, they argue that the average primary balance required to stabilise the public debt/GDP ratio at the 2007 level would have to be 11.8 per cent for Ireland, 10.1 per cent for Japan, 10.6 per cent for the United Kingdom and 8.1 per cent for the United States.

Even if the nations followed their 10 or 20 year projections, we would be back in a deeper mess than we have been in over the last few years.

Why are they so hung up?

The BIS authors close by stating what they believe the problems of public debt ratios are.

First, “higher risk premia and increased cost” via bond market assessments (as evidenced by rising CDSs). Answer: ban most of this speculative activity and use the central bank to control the yield curve if that is a worry.

They then say that:

… a second risk associated with high levels of public debt comes from potentially lower long-term growth. A higher level of public debt implies that a larger share of society’s resources is permanently being spent servicing the debt. This means that a government intent on maintaining a given level of public services and transfers must raise taxes as debt increases.

This is a typical maintream argument that is based on the false notion that taxes are used to finance government spending. But they are clearly conflating financial transactions between the government and non-government sector with the use of real resources. That conflation is misleading and likely to be erroneous.

For example, in the UK and the US, in particular there have been huge build-ups in bank reserves with virtually zero impact on aggregate demand. The transactions have altered financial portfolios but not engaged very many real goods and services.

Similarly, debt servicing by government doesn’t take any real resources away from the non-government sector. It adds income which can be used to purchase real goods and services. But the meagre act of crediting a bank account as the government pays its servicing obligations doesn’t imply “that a larger share of society’s resources is permanently being spent servicing the debt”.

Whether governments raise taxes in the future depends on the state of aggregate demand. They may or may not. But it will have very little to do with the public debt situation.

Thirdly, we get hit with the “crowding out” argument:

The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital.

The government borrows back what it has spent. There is no finite pool of saving. Saving expands with income and income responds to aggregate demand which government net spending adds to.

There is no systematic relationship ever been found between real interest rates and budget deficits that stands up to scrutiny.

The only crowding out that matters is whether there are real goods and services available. If they are fully utilised then if the governments wants to increase its command on them they have to deprive the non-government sector. That is crowding out!

The existence of a higher level of public debt is likely to reduce both the size and the effectiveness of any future fiscal response to an adverse shock. Since policy cannot play its stabilising role, a more indebted economy will be more volatile.

The only things that limit the capacity of fiscal policy to respond to a negative shock are the availability of real goods and services to purchase and the political climate that the government faces. Neither of these limitations are “financial”. A government could spend whatever it wanted to irrespective of its past fiscal history.

Conclusion

Will someone write to the BIS and ask that these authors be sacked for poor work standards and misleading the public? Thanks.

22 Responses to Another economics department to close

Japan’s debt is domestic so they cant default. Australia on the other hand finances a big part of its bank lending from O/S.
Why are Australian Banks forced to go overseas for funds when the Gov as a sovereign could print the money the banks need to lend to its people for housing and small business investment? Anyone help with this one?

i got thinking about it, when posting on a another blog , defending mmt’s position on government deficits, of which im in broad agreement. i know , i know, your thinking with friends like these who needs enemies.

but it did get me wondering what mmt’s postion was on our foreign private debt.

would be great if you could do a piece on it, if you havnt done one allready

I mean historically there are plenty of examples of national governments getting themselves into debt and then either inflating their way out of it (which leads to worse issues) or defaulting. Without those two options available what other solutions are there apart from fiscal austerity?

I can understand how MMT creates government funds from seigniorage and then balances out inflation through taxes, but until that time comes governments have to be able to pay back money they borrow from the non-government sector.

Would you care to list the examples of sovereign governments with flexible exchange rates that have defaulted on debt denominated in their own currency? Seeing as you think there are plenty of them? You will find none!

Would you care to list the examples – historical periods etc – where national governments have deliberately inflated away the real value of their outstanding debt?

Further, MMT does not create government funds through “seigniorage” – the latter is a gold standard concept that has no application in a modern fiat currency system.

And where have I ever said that the public debt and its servicing is not a legal obligation (liability) on all governments?

“Without those two options available what other solutions are there apart from fiscal austerity?”

well if we are talking about the euro zone, the greeks , the irish, the spanish and anyone else silly enough to sign up to monetary union, could give brussells the 2 fingered salute and go back using their own currency, and stimulating domestic demand and local productive capacity through running large government deficits, which at present they are legally constrained from doing so. it beggars belief that these governments would stick it to their own people than stick it to the euro and the bankrupt ideas that support it.

it will be interesting to see if some of these characters lose their heads over this, which has happened in european history from time to time

Bill,
Great show.
And an important topic.
I don’t agree that the problem is the economists.
They’re just hauling the dirt.
The main reason we remain in the thought-rut that this BIS paper maintains is the same as the real reason why the Notre Dame EPSD shut down.
It is the need to maintain the status quo and to ensure that the wealthy elite that control international finance don’t lose a step, maybe gain a step, in this chaos.
In a debt-money system, where the success of financialization is to command greater and greater portions of the money system just to service the debts that engender that money system, there MUST be a squeeze on wages, jobs, benefits and local governments, in order for the status quo monied interests to prevail.
When you get up through the WB-IMF-BIS heirarchy, there ain’t much room for real research.
The question from we extreme monetary heretics, Bill, is who is working on the exit strategy FROM the debt-money system?
From that point, all of this represents a historic monetary tragi-comedy.
May I trust that your blogpost is sent directly to the BIS scribes?
Best.
joe

Lucky Punch: Not a bad question. Australian banks aren’t “forced” to go overseas for funds: they choose to. In a free market presumably they should have this freedom, though this makes maintaining interest rate policy in particular countries difficult. That is govts raise rates to impose deflation. If commercial banks then draw money into the country, this counters the latter intended deflationary effect, which is awkward for govt.

A related and perhaps better question is why (in heaven’s name) do governments that issue their own currency borrow at all (never mind borrow from abroad). I.e. why does the organisation that has the power to print dollars need to borrow them? It’s a bit like a dairy farmer buying milk in a shop.

Personally I think the latter government borrowing is bonkers. I.e. national debts could be reduced to near zero. Milton Friedman argued for a near zero national debt here:

When this “Friedman/Mosler” policy is adopted, interest paying national debt to significant extent is replaced with monetary base (which pays little or no interest). That’s what the U.S. should do. And if foreign entities like the Japanese, Chinese and Brits want interest, the U.S. could just tell ‘em to whistle for it.

An excellent post as always, but there is one area which I think is worthy of additional comment:

“Next stop is the interest rate explosion that is about to happen which will cause:

… the debt ratio will explode in the absence of a sufficiently large primary surplus.

At which point the governments either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.

Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided.”

There is no answer provided because, as you rightly note, as a point of economic logic, your argument is irrefutable. BUT as any regular observer of the markets can tell you, bond yields have risen significantly in the past few weeks, notably in the US. This might have occurred for the dumbest reasons imaginable (one person foolishly tried to link the rise in US yields to Portugal’s downgrade by the benighted ratings agencies).

On the other hand, one of the great insights of George Soros was the notion that markets could act on incorrect or imperfect information and thereby create a new kind of economic reality. It might well be that very few understand MMT or basic public reserve accounting, but there you are.

The Fed, then, has a dilemma. It needs to finesse expectations management for BOTH Treasury bond and equity investors.

Bond investors need to know they are not going to get screwed by inflation, so they want the fed funds rate renormalized.

Equity investors want the “extended period” of ZIRP to last for, well, an extended period. Free money is good for specs.

So what is the Fed to do?

I discussed this recently with Rob Parenteau and he cleverly suggested a modern version of “Operation Twist”, which was implemented originally by the Fed in 1961 to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. It was only marginally successful.

So why should it work better today?

Well, the Fed has more tools thanks to its policy of paying interest on excess reserves (IOER). Scott Fullwiler has an excellent paper on this (“Paying Interest on Reserve Balances: It’s More Significant than You Think”), where he demonstrates that this action severs the relationship between the policy rate target and the level of reserves outstanding (if there ever was one – some indications in recent years were that all Fed had to do was announce new fed funds rate target, and primary dealers would take it there, knowing Fed had capacity to change reserves outstanding – all of which meant Fed did not have to change reserves, since they had a credible threat they could, making the textbook story about Fed ops even more outdated and incorrect).

So the Fed can everybody that they are renormalizing the fed funds rate and take the IOER up to 100bps. As Rob said, they don’t need to remove any reserves to do this – they just do it administratively. That’s how the IOER works – it severes the link between reserves in the system and the target policy rate, right?

Then, if the bond gods don’t rally Treasuries on the Fed’s efforts to renormalize the policy rate, they call up Bill Dudley (President at the NY Fed) and give him instruction to buy all the 10 year UST on offer until the 10 year UST yield is down to, oh , say 3.5%. It is an open market operation, which the Fed performs all the time. They won’t have to call it QE, but it is in effect the same thing

Then, every time some big swinging dick bond trader tries to push it above 3.5% by shorting Treasuries, you slam their face into the concrete by having the
the open market desk buy the hell out of UST until the 10 year yield is back to 3.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.

Operation Twist, Part Deux. Only way to finesse the expectations management dilemma, unless you want to take up the 1989 recommendation by one of your fore-Governors, to go operate in the equity futures market.
It seems to me that we are now approaching a very critical juncture in terms of potentially settling the debate between those who think that central banks establish the rate structure (as you and I and indeed most readers of this blog believe) vs those who believe that this is done by the markets (such as the writer of the BIS report and, needless to say, what’s left of the economics department at Notre Dame). There is a policy that can be put in place. I doubt it will happen, but I think it’s an important consideration when dealing with an argument to confront today’s current market realities.

Thanks Ralph.
I have read the Mosler proposal. I like Mosler’s description of the banks as a public private partnership. Banks as lenders seem to be a distribution center for Money in the same way supermarkets are distribution centers for food. If a population need funds to build houses for each other I cant see why it is necessary for Banks as lenders to borrow these funds from international markets in foreign currency hedged then distributed as loans. From what I have learned so far about MMT it seem logical that a Sovereign Country should supply the domestic lender Banks with funds in sufficient quantities to create housing for its people. Why borrow O/S for domestic use? I will download Milton Friedman’s proposal, thanks again. Punchy.

1. Regarding optimal discretionary fiscal policy, there is a danger here. Taking the position that sovereign states have shown consistently discretionary fiscal contraction bias can somebody erroneously conclude that fiscal policy mistakes are the main source of (under/un)employment. This is a similar strong statement taken by monetarists when they argue that an expansionary monetary policy is the main source of inflation. As you know and recognize there are other sources of underemployment, involuntary unemployment, capitalist and finacial instability proposed by Marx, other Marxists, Keynes, Kalecki, Minsky and many other PostKeynesians. I suggest you add some qualifiers in your statements of MMT so there is no confusion.

2. Regarding interest rates of public debt, in a comment I posted in your recent blog on Greece I pointed out that austerity measures can very well lead into higher interest rate spreads as the consequences of fiscal discipline raises the probabilty of default estimated by the markets which is the opposite effect of what conventional theory proposes. Notice that this applies to all economies that face voluntary(market/political/media) and involuntary revenue constraints as I have demonstrated in some previous comments I made in earlier blogs of your site.

OK, I have a question. Sorry if it’s a bit offtopic, but I’ve been reading this blog all over the place :)

I get that the government isn’t revenue constrained, that they don’t actually ‘print’ money (although I can’t see any real difference between printing money and creating bank reserves), that they ‘fund deficits through borrowing’ simply to keep the interest rate up, and that inflation only occurs when there is demand competition for scarce resources and no spare capacity in the economy.

My question is : why would anybody think that a government paying for things by printing bonds ( or ‘funding deficits through borrowing’ as they put it ) make any difference to inflation, compared to paying for things by printing money?

It seems to me that a treasury bond is just money that earns interest – or to put it the other way around, that a dollar bill (or a bank reserve) is just a treasury bond that has already matured. They are both just an IOU from the government. After all, surely anyone with a treasury bond can pretty much just buy things with it, or if they really need cash just ‘repo’ it to a bank for much the same NPV as they paid for it and get the bank to ‘print’ the money (create a deposit against a loan that will be paid back when the bond matures) for a relatively small fee?

(Incidentally, can anyone who knows anything about actual financial markets tell me the difference between treasury bond yeilds and the interest on a ‘repo’ for the same bond? Or where I could find it?)

Is it just the enduring fantasies of ‘money supply’ and ‘fractional reserve banking’, which I find it hard to believe any of the actual players in finance subscribe to? Or is there some real difference between treasury bonds and money that I’m not seeing, other than the slight unpredictability of the NPV of a bond?

And if I am right, why should the government ‘printing money’ to buy back all its debt have any inflationary effect at all, other than one that might result from the drop in interest rates that they would have to let happen? It seems to me that to all intents and purposes the money was already ‘printed’ when the bond was issued, and that any inflation that was going to happen has already done so.

” why would anybody think that a government paying for things by printing bonds ( or ‘funding deficits through borrowing’ as they put it ) make any difference to inflation, compared to paying for things by printing money?

Great question……. I suggest you go ask this at a lot of other places though because it is very hard for people who dont suffer from that flawed reasoning to actually speculate why someone would.

“Is it just the enduring fantasies of ‘money supply’ and ‘fractional reserve banking’, which I find it hard to believe any of the actual players in finance subscribe to?”

I think you are on to something here. It probably has a lot to do with ideology and the fact that what is in finance books still has gold standard language. But its really hard to understand others delusions.

“And if I am right, why should the government ‘printing money’ to buy back all its debt have any inflationary effect at all, other than one that might result from the drop in interest rates that they would have to let happen? It seems to me that to all intents and purposes the money was already ‘printed’ when the bond was issued, and that any inflation that was going to happen has already done so.”

You havent spent much time here but you’ve gotten to the core pretty quickly. Not sure why its so hard for some people. All money in circulation (and in bonds) was spent first by the govt. It never needs to get money from us to spend…………….never.

Marshall Auerback,
Why would you want to increase the IOER to 100 bps? This is not a prerequisite for the Fed to take the 10 year UST to 3.5% at all. I would leave the IOER unchanged, and just start buying 10 year USt until yields decrease to 3.5%, and let excess reserves grow in the process (still earning 0.25%). You may be punishing equity speculators by taking short term rates to 1%, but you are going to punish a whole bunch of guys that have legitimate variable rate credit margin as well. Bringing the IOER to 100bps is basically carpet bombing a city to make sure the mayor is killed.

Begruntled: You pose a good question: “why would anybody think that a government paying for things by printing bonds ( or ‘funding deficits through borrowing’ as they put it ) make any difference to inflation, compared to paying for things by printing money?”

My answer is that you are pretty well right: there is little difference between the two. William Beveridge, founder of the British welfare state, actually made this point in the 1940s. However, I think there IS a FINITE difference between the two: bonds are no quite as liquid as cash. But the difference is not large.

You also ask, “And if I am right, why should the government ‘printing money’ to buy back all its debt have any inflationary effect at all”. My answer to that is that there WOULD BE a finite reflationary effect (which might or might not lead to inflation). This is because where government offers interest on the bits of paper it issues, the private sector will want to hold more of such paper than where no interest is offered (as is the case, normally, with cash or monetary base). I.e. if bondholders are given cash for their bonds, they will then try to dissave money to some extent, which is reflationary (opposite effect to the paradox of thrift).

I actually put a blog on the net about a month ago arguing for what you suggest. I.e. I argue that (contrary to conventional wisdom) it would be perfectly feasible to pay off a national debt (partially by printing more money and buying it back). I also argue that this can be done AT THE SAME TIME AS maintaining or expanding economic stimulus. See http://cutdebt.blogspot.com/ I.e. I’m arguing for something similar to the Friedman/Mosler idea I mentioned in my first comment above.

I read your blog and I am responding here since I cannot access your comments section.

1. The mix of fiscal contraction /QE is not neutral in the case where the foreign sector owns public debt as their spending has a “leakage” abroad while fiscal contraction has a drag effect domestically.

2. The proposed prescription for rducing public debt has horizontal allocation and vertical income generation effects. You take the money from wage earners that pay taxes and public spending programs and give it to owners of public debt who are usually more wealthy and also have a higher (MPS) so the income multiplier and icome generation are lower.

@Greg
Asking somewhere else – I wouldn’t know where to start :) This is the first economics discussion I have seen that made enough sense to me to feel I could ask anything.

@Ralph
Ah, good point thanks, reduced propensity to save = more money in play, to some finite marginal extent, which could be (as you rightly correct me) reflationary.

I liked your blog. I think for me I am more comfortable thinking of the money base as government debt, in as much as it is redeemable for tax relief. That lets me simplify my rhetorical argument down to :
– government deficit spending is *automatically* funded by borrowing, because even printing money is borrowing. The only question is the interest rate
– the governments debt *is* the sum total of the people’s savings, both as to size and to interest. After all, who else is the government in debt to, and who are the people lending to?
leaving out the whole foreign sector and lots of other details, obviously (and apologies to bill for putting it all backwards on what is after all his blog) . That way of putting it seems, for me at least, to cut through the rhetoric about fiscal discipline and soaring debt.

But I confess to being a bit disturbed that no-one has popped up and pointed out something big I missed. I mean, this means 99% of all the stuff that gets talked about economics is just pure blither.

I can answer the bond yield vs repo rate distinction. First, recognize anything that has a discernable value can in theory be repo’d, as a repo is simply a fully collaterized loan. The repo rate on liquid financial instruments (including the treasury bond in your question) is simply the rate on the loan. In the interbank market, a generic treasury bond submitted as collateral for an overnite loan will trade either side of fed funds (this is the General Collateral, or ‘GC market’). The particular yield on the treasury bond on that day plays no part in the repo.

I get (I think) that the current ‘yeild’ on a bond (which is a bond market decision) has nothing to do with the interest rate you can ‘repo’ it for (which is at core a central bank decision). I was hoping for some idea of how the two numbers compare (do they, in practice, diverge all that much?) to go with my idea that there really isn’t much difference between bonds and money.

Panayotis: thanks for your interest. Rather than clutter up Bill’s blog with my response, I’ll copy your comment to my blog and answered it there. I assume you are referring to the “Let’s cut the national debt….” blog.

sorry for taking so long to reply – I have had it in my mind for some days to respond, especially when you have asked the question twice. So please accept my apologies.

You asked (I edited it a bit):

Just a question re bank overseas borrowing. Are their borrowings denominated in source country currency , and if not how does the transaction work accounts wise. Could you lead me to any sources looking at this process
I’m curious about our foreign debt position, and our vulnerabilities re this. I got thinking about it, when posting on a another blog , defending MMM’s position on government deficits, of which I’m in broad agreement. I know , I know, your thinking with friends like these who needs enemies. But it did get me wondering what MMM’s position was on our foreign private debt.

The Australian banks borrow in both $As and foreign currencies. You can see data on off-shore borrowings by the Australian Financial Institutions (AFIs) at the RBA. In February 2010, Broad Money was $A1238 and Off-shore borrowings by the AFIs was $A337.3 billion around 27.2 per cent.

Much of this borrowing goes into housing mortgages and related DIY expenditure. It has grown substantially in the last decade in line with the real estate boom. The MMT position is that the growth possibilities that can be derived from private leverage are finite. In general, the private sector cannot increase its indebtedness forever and eventually the sector will attempt to save, which is what is going on at present. Growth therefore can only be sustained if this process is supported by public deficit given that Australia runs a current account deficit.

The question of how much foreign borrowing is sensible is difficult to answer. Clearly the situation in Latvia and Estonia and elsewhere where up to 80 per cent of the mortgage market debt is written in foreign currencies is madness. In Australia, that is not legal and so the foreign exchange risk is being borne by the banks (or the counterparties they hedge with) and the home owner is fine.

I suspect if we trimmed the financial sector (for example, banned OTC transactions) then a proportion of this foreign debt would decline. But as long as the private banks have adequate capital holdings (and assets to back them) there is nothing intrinsically wrong with borrowing from foreign capital markets. I would also force the banks to buy deposit insurance in Australia.

From a MMT perspective, the most important point is that the national government never borrows in a foreign currency. Once they do that they lose their sovereignty and expose themselves to insolvency risk.

“From a MMT perspective, the most important point is that the national government never borrows in a foreign currency. Once they do that they lose their sovereignty and expose themselves to insolvency risk.”

Highly unlikely any government could live by those rules. How would anyone convince governments not to import millitary hardware?